Cody v. Securities & Exchange Commission

United States Court of Appeals
For the First Circuit
No. 11-2247
RICHARD G. CODY,
Petitioner,
v.
SECURITIES AND EXCHANGE COMMISSION,
Respondent.
PETITION FOR REVIEW OF AN ORDER
OF THE SECURITIES AND EXCHANGE COMMISSION
Before
Boudin, Hawkins* and Thompson,
Circuit Judges.
Stephen Z. Frank with whom Law Office of Stephen Z. Frank was
on brief for petitioner.
Daniel Staroselsky, Senior Counsel, Securities and Exchange
Commission, with whom Mark D. Cahn, General Counsel, Michael A.
Conley, Deputy General Counsel, Jacob H. Stillman, Solicitor, and
Randall W. Quinn, Assistant General Counsel, were on brief for
respondent.
September 7, 2012
*
Of the Ninth Circuit, sitting by designation.
BOUDIN, Circuit Judge. Richard G. Cody seeks review in
this court of an administrative determination, sustained by the
Securities and Exchange Commission ("SEC"), that Cody mismanaged
various brokerage accounts under his supervision. The original
determination including sanctions was made by the Financial
Industry Regulatory Authority ("FINRA"). A reasonably full
description of the underlying events and evidence is required.
In 1996 Cody became a "registered representative" in the
securities industry, that is, a person who has passed an
examination administered by FINRA and obtained a license to
solicit, purchase, and sell securities while working with a member
firm of FINRA. In practice, his clients often allow him to
exercise de facto control over their accounts, whereby he consults
the clients about general strategies but routinely executes
specific trades on behalf of his clients without first asking for
their authorization.
During his career he has worked for several different
brokerage houses including Merrill Lynch and Salomon Smith Barney
but between 2001 and 2005, he worked at Leerink Swann & Co.
("Leerink"). In 2003-2004, he made investments for two couples--
Richard and Lenore DeSimone and James and Emma Bates--certain of
which are the centerpiece of this case. These four were near or in
retirement, were not skilled investors, and expressed no interest
in acquiring speculative investments for the accounts at issue.
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The DeSimones told Cody they desired investments that
would be relatively safe but that would provide steady income they
needed to fund their retirement. Lenore DeSimone had held a 401(k)
that carried mutual funds for about twenty years, and the DeSimones
had also held savings accounts, savings bonds, and a small account
previously managed by another broker. At issue are two of the
DeSimones' several accounts: Lenore DeSimone's IRA and a joint
account. For both the IRA and the joint account, the DeSimones
listed an investment objective of "long-term growth."
The DeSimones asked Cody to pursue a strategy of
investing in safe, highly-rated bonds with maturity dates of around
ten years. They told Cody they were relying on his expertise to
execute this strategy in a way that would protect their
investments. On Cody's records, the IRA listed a risk tolerance of
"moderate" while the joint account listed a risk tolerance of
"speculation," but Lenore DeSimone testified that she believed that
Cody filled out the risk tolerance entry, and Cody conceded that
the DeSimones were not interested in speculation.
James and Emma Bates were friends of the DeSimones, who
introduced them to Cody, and in February 2003, James Bates opened
an IRA with Cody. James Bates' IRA initially contained assets of
$380,046; James Bates hoped that the account would generate a
monthly income of $2,000, which equated to an annual return of
approximately 6.3 percent. In his account opening forms, James
-3-
Bates listed an investment objective of "income" and a risk
tolerance of "low." Cody advised James Bates that he could achieve
the desired income while maintaining low risk by investing in
bonds.
In February 2003, Cody invested money from James Bates'
IRA and the DeSimones' joint account in the Credit Suisse First
Boston Mortgage Securities Corp. IndyMac Manufactured Housing
Passthru (the "Credit Suisse Security"), a fixed-income security.
Cody invested $86,500 from James Bates' IRA (23 percent of the
total account) and $31,725 from the DeSimones' joint account (13
percent of the total account) in the security. The Credit Suisse
Security was collateralized by installment sales contracts and
installment loans for mobile homes.
The Credit Suisse Security was one of eleven "tranches"
of securities collateralized by the same set of assets; its tranche
was eighth out of the eleven in order of priority. This meant that
the security was eighth in line to receive payments, and fourth out
of the eleven to bear losses if the borrowers defaulted on their
payments. The security carried a 7.105 percent coupon and had a
stated maturity of February 2028, but the borrowers had the option
of prepaying the underlying installment loans and contracts.
Cody invested his clients' funds in the Credit Suisse
Security after it was recommended by a colleague at Leerink,
Timothy Skelly, who specialized in fixed-income securities. Skelly
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gave Cody basic information--e.g., the issuer, the coupon
percentage, the date of maturity, the nature of the collateral and
the chance for prepayment--and gave him a printout from Bloomberg,
but Cody did not seek out further information.
Cody knew that the security had an A rating, but did not
know that it had been downgraded from AA by Fitch in October 2002.
When asked whether he "really understood" the security at the time
of the investments, Cody admitted, "At the time I sold it to them
I didn't really look at a CMO [collateralized mortgage obligation]
to be significantly different than any other bond; obviously, I've
learned quite a bit since then." Cody bought the security the day
after Skelly first mentioned them.
Over the next year, the Credit Suisse Security was
downgraded several more times, with the Fitch rating declining to
CCC in February 2004. The market price of the security dropped
from $104 in February 2003 to $41 by February 2004. Over the next
three months, Cody sold the DeSimones' investment at a loss of
$17,377 (55 percent of their initial investment) and James Bates'
investment at a loss of $56,868 (66 percent of his investment).
In 2003, Cody invested James Bates' money in three non-
investment grade bonds. A bond with a rating of BBB- or higher
from Standard and Poor's or Fitch or Baa3 or higher from Moody's is
considered investment grade. Non-investment grade bonds, often
referred to as "junk" bonds, have a rating of BB+ or lower from
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Standard and Poor's or Fitch or Ba1 or lower from Moody's, and are
considered to be speculative, with a higher degree of credit risk.
Fabozzi, Bond Markets, Analysis, and Strategies 162-63 (6th ed.
2007).
These investments were made in May 2003, when Cody
purchased Ahold Financial USA Inc. bonds, and in June, when he
purchased Calpine Corp. and Royal Caribbean Cruises, Ltd. bonds.
The Ahold and Calpine bonds were rated B1 by Moody's, and the Royal
Caribbean bonds were rated Ba2 by Moody's. These bonds totaled
about 23 percent of the market value of James Bates' IRA. Between
July and November 2003, Cody sold all of the bonds, realizing a
small gain on the investment, but the ratings were nevertheless for
speculative grade bonds.
Cody engaged in frequent trading in 2003 and 2004 in
James Bates' and Lenore DeSimone's IRAs. Cody made 140 trades (84
purchases and 56 sales) in Lenore DeSimone's IRA from June 2003
through May 2004. He engaged in a pattern of in-and-out trading,
purchasing several securities and then selling those same
securities just weeks later. The purchases totaled more than $1.3
million, while the average value of the account was just $421,000.
The trades generated over $36,000 in commissions to
Leerink, with Cody personally getting over $14,000 in commissions.
During that period, the account had a turnover ratio (annual
purchases over average account value) of 3.4 and a commission to
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equity ratio of 8.7 percent, meaning that the investments in the
account would need to earn approximately 8.7 percent in annual
returns just to break even after commissions.
In James Bates' account, Cody made 108 trades (69
purchases and 39 sales) from February 2003 through May 2004.
Although there was not sufficiently precise information available
to calculate turnover or commission ratios for this account, Cody
made purchases of approximately $1.7 million during the 16-month
period, when the total value of the account at the end of the month
was always less than $475,000.
In addition, Cody employed a strategy of in-and-out
trading and generated over $41,000 in commissions for Leerink, of
which over $17,000 went to Cody. Around May 2004, Emma Bates
questioned Cody about the trading in James Bates' account, and the
level of trading in both James Bates' and Lenore DeSimone's
accounts subsequently declined.
Cody also seemingly misled his clients in a number of his
monthly reports by reporting bonds at par value, without a clear
indication that this was so even when their market value was well
below that figure, significantly overstating the value of their
portfolios. After Cody left Leerink, Cody settled with the Bateses
and DeSimones, agreeing to compensate the DeSimones $20,000 and the
Bateses $56,000 for their losses on the Credit Suisse Security, but
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he delayed the required reporting of this information to FINRA for
over two years.
On January 11, 2008, the Department of Enforcement of
FINRA filed a complaint against Cody. FINRA is a self-regulatory
organization (SRO) that regulates professionals and firms in the
securities industry, inheriting the responsibilities of two earlier
similar bodies. Under the Securities Exchange Act, SROs such as
FINRA can discipline members with penalties including expulsion,
suspensions, and fines but must provide a hearing and written
opinion and allow an administrative appeal. Loss, Seligman &
Paredes, 6 Securities Regulation 199-200.
The complaint alleged violations of NASD Rule 2310 and
NASD Rule 2110.1 Rule 2310 requires:
In recommending to a customer the purchase,
sale or exchange of any security, a member
shall have reasonable grounds for believing
that the recommendation is suitable for such
customer upon the basis of the facts, if any,
disclosed by such customer as to his other
security holdings and as to his financial
situation and needs.
Rule 2110 requires representatives to "observe high standards of
commercial honor and just and equitable principles of trade."
After a lengthy period of discovery, a three-member FINRA
Hearing Panel conducted a five-day hearing from October 27, 2008,
1
Because Cody's disputed conduct took place before FINRA
amalgamated the functions of the National Association of Securities
Dealers ("NASD") and the regulatory arm of the New York Stock
Exchange ("NYSE"), the NASD pre-merger conduct rules applied.
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through October 31, 2008. At the hearing, Cody was represented by
counsel, both sides presented documentary evidence, both sides
called witnesses and cross-examined the other side's witnesses, and
Cody himself testified. The panel issued a written decision on
January 29, 2009; the panel (unanimously) found
-that in violation of Rule 2310 and Rule 2110
Cody engaged in excessive trading of Lenore
DeSimone's and James Bates' IRA accounts by
conducting in-and-out trading for risk averse
investors in a way that generated substantial
commissions for Cody and Leerink;
-that (again citing both rules) the
investments in the Credit Suisse Security were
unsuitable because Cody did not understand the
risks involved in the security [Add. 12-13],
and the purchase of non-investment grade bonds
for James Bates was unsuitable given James
Bates' low risk tolerance; and
-that in violation of Rule 2110 Cody's monthly
statements were misleading and he improperly
delayed the required reporting of his
settlements with his clients.
The Hearing Panel imposed a fine of $20,000 and a three-
month suspension for the unsuitable purchases and in-and-out
trading (one panel member urged six months), a $5,000 fine for the
misleading statements, and a $2,500 fine for the delayed reporting,
producing a total fine of $27,500 (along with costs of $7,087.50)
and a three-month suspension. Both sides appealed and the Appeals
Panel upheld liability (save on one unimportant detail) and
affirmed all fines, and increased the suspension to a year,
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concluding that a "stronger sanction is needed to remedy Cody's
violations."
Cody petitioned the SEC to overturn the FINRA findings
and penalties, save for the ruling about the monthly statements and
delayed reporting of settlements, and the associated $7,500 in
fines. The SEC, reviewing the record de novo and considering
briefs from both sides, affirmed the liability findings on a
preponderance of the evidence standard and affirmed the appellate
body's sanctions, finding that they were not unnecessary or
inappropriate or excessive or oppressive, the standard required for
reversal of sanctions. 15 U.S.C. § 78s(e)(2) (2006).
In this court, we review the order of the SEC rather than
FINRA's decisions. See 15 U.S.C. § 78y(a)(1); Krull v. SEC, 248
F.3d 907, 911 (9th Cir. 2001). The SEC's factual findings control
if supported by substantial evidence, 15 U.S.C. § 78y(a)(4); A.J.
White & Co. v. SEC, 556 F.2d 619, 621 (1st Cir.), cert. denied 434
U.S. 969 (1977), and its orders and conclusions must not be
"arbitrary, capricious, an abuse of discretion, or otherwise not in
accordance with law." 5 U.S.C. § 706(2)(A) (2006).
Cody challenges the SEC's action on a number of grounds
but, in the end, none is substantial. He begins by arguing that
FINRA itself is a "state actor" endowed with governmental powers
and is therefore required to provide due process under the Fifth
Amendment. Two circuits have said no, others have expressed doubt
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and one has dicta referring to due process as governing NASD
rules.2 There may be other such cases. This circuit has not
addressed the issue, and it would be pointless to do so here.
By statute, FINRA was required to give Cody the substance
of procedural due process. Gold v. SEC, 48 F.3d 987, 991 (7th Cir.
1995). In addition to providing "fair procedure," an SRO must
"bring specific charges, notify such member or person of, and give
him an opportunity to defend against, such charges, and keep a
record." 15 U.S.C. § 78o-3(b)(8), (h)(1). FINRA did so here; and
Cody nowhere explains just what would have been different if the
administrative process for collecting evidence, compiling the
record, evaluating Cody's conduct and imposing a sanction had been
done in the first instance by the SEC itself.
The closest Cody comes is to argue that the Hearing Panel
erred in refusing his request to offer expert testimony. The
panel, like a court, had "broad discretion," Dep't of Enforcement
v. Strong, No. E8A2003091501, 2008 FINRA Discip. LEXIS 19, at *17
(FINRA NAC Aug. 13, 2008), to exclude all evidence that is
"irrelevant, immaterial, unduly repetitious, or unduly
2
Compare Desiderio v. Nat'l Ass'n of Sec. Dealers, Inc., 191
F.3d 198, 206 (2d Cir. 1999), cert. denied 531 U.S. 1069 (2001)
(rejecting the state actor claim), and Epstein v. SEC, 416 Fed.
Appx. 142, 148 (3d Cir. 2010) (unpublished opinion)(same), with
Jones v. SEC, 115 F.3d 1173, 1183 (4th Cir. 1997), cert. denied 523
U.S. 1072 (1998), and Gold v. SEC, 48 F.3d 987, 991 (7th Cir.
1995)(expressing doubts), with Rooms v. SEC, 444 F.3d 1208, 1214
(10th Cir. 2006)(dicta that due process requires that a NASD rule
give fair warning).
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prejudicial." NASD Rule 9263(a). Cody sought to offer the
testimony of Gerald A. Guild as an expert in fixed-income
securities, but the Hearing Panel said it "would not be necessary
or helpful to the Panel." A similar offer to the Appeals Panel was
similarly rejected.
A panel comprised of those experienced in the industry
was obviously less in need of expert advice than an ordinary judge
or jury. But even in court a lawyer seeking to present expert
testimony will, if doubts are expressed, need to tell the judge the
substance of the proposed testimony and why it is needed. At the
FINRA proceeding, Cody failed to do so; indeed, even today Cody
does not tell us just what his expert was proposing to say.
Without it, FINRA had no reason to conclude that the evidence was
valuable, and nor do we.
Cody's next objection relates to the multiple roles
played by attorney Michael Garawski, FINRA Associate General
Counsel, who served as the Appeals Panel's counsel during Cody's
administrative appeal, a role in which he ruled on various
procedural motions by the parties. After Cody appealed the Appeals
Panel's decision to the SEC, Garawski represented FINRA before the
SEC, and was the attorney who signed FINRA's brief. Cody contends
that Garawski's "dual role as adjudicator and advocate biased the
outcome of the administrative proceedings."
-12-
The objection is not on its face a promising one.
Government agencies, including the SEC itself, initially play the
role of adjudicator when they resolve complaints and then in turn
advocate when defending their resolution in court. This is not the
same thing as taking sides as an advocate in a proceeding and then
purporting to adjudicate the disposition or the appeal from it.
But something might turn on the circumstances and we have no
occasion to explore the matter here because the objection has been
forfeited.
Garawski openly assumed the dual role; Garawski's role at
the FINRA Appeals Panel was known to Cody before FINRA's
proceedings were over, and his role as an advocate before the SEC
was known before the SEC proceedings were over. To preserve this
issue for review, Cody had to raise it before the SEC and failed to
do so. By statute, "[n]o objection to the order of the [SEC] shall
be considered by the court unless such objection shall have been
urged before the Commission or unless there were reasonable grounds
for failure to do so." 15 U.S.C. § 80b-13(a). See Armstrong v.
SEC, No. 09-1260, 2012 WL 1448980, at *2 (D.C. Cir. Apr. 25, 2012)
(per curiam); Dyer v. SEC, 290 F.2d 534, 539 (8th Cir. 1961). That
ends the matter.
Turning from procedural claims of error to substance,
Cody argues that his choice of the Credit Suisse Security did not
violate the suitability rule. Remarkably, he argues that an
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investment recommendation is unsuitable only if the investment "on
its face, is unsuitable for any investor." Appellant's Br. 37
(emphasis added). Cody's interpretation conflicts both with the
rule's text and with any realistic policy designed to protect
investors according to their circumstances.
The suitability rule requires reasonable grounds for the
recommender to believe that "the recommendation is suitable for
such customer upon the basis of the facts, if any, disclosed by
such customer as to his other security holdings and as to his
financial situation and needs." NASD Rule 2310 (emphasis added);
see also F. J. Kaufman & Co. of Va., 50 S.E.C. 164, 168 (1989)
(requiring "a customer-specific determination of suitability").
And it is common sense that an investment that is suitable for some
investors may be unsuitable for other investors with completely
different investment objectives.
Cody also objects that, contrary to the findings of FINRA
and the SEC, he had a sufficient understanding of the security to
recommend it. The fact that he recommended a risky security to
customers who made clear their preference for safety strongly
supports the opposite conclusion, and anyway Cody admitted at the
FINRA hearing, "At the time I sold it to them I didn't really look
at a CMO [collateralized mortgage obligation] to be significantly
different than any other bond; obviously, I've learned quite a bit
since then."
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In particular, Cody did not know that the security's
credit rating had been recently downgraded, he did not know that
the security was one of the riskiest tranches of securities
collateralized by the same pool of assets, and by his own
admission, he did not understand that securities collateralized by
housing assets have fundamentally different risks than traditional
bonds that are backed by the credit of a government or a
corporation. Nor does Skelly's recommendation immunize Cody. The
responsibility to investigate belonged to Cody and the findings
against him are plainly supported.
Finally, with regard to the Credit Suisse Security, Cody
claims that he was misled or the Appeals Panel erred because in the
hearing the security was often referred to as a collateralized
mortgage obligation (CMO), while the Appeals Panel called the
security an asset-backed security (ABS). But Cody had meaningful
and adequate notice, and at no point was confused as to which
securities were at issue.
ABSs are in some locutions a general class of all
securities collateralized by financial assets while in the case of
CMOs the assets happen to be mortgages.3 Quite likely, the loans
3
CMOs are defined as a class of ABSs by the Securities
Exchange Act. See 15 U.S.C.A. § 78c(a)(79) (West 2012) ("The term
'asset-backed security'-- (A) means a fixed-income or other
security collateralized by any type of self-liquidating financial
asset . . . including--(I) a collateralized mortgage obligation .
. . .").
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and sales contracts in the Credit Suisse Security were secured by
some kind of property interest in the mobile homes that could
loosely be described as a chattel mortgage. Indeed, he testified
that when he first learned of it Skelly informed him that the
Credit Suisse Security "was an asset-backed security supported by
mortgages on homes."
Even if the Credit Suisse Security arguably might be
called something other than a CMO, on the theory that it was
collateralized by assets other than mortgages, the FINRA complaint
was sufficiently detailed to inform Cody that he was being charged
with unsuitable recommendations of the Credit Suisse Security,
regardless of whether it was better labeled a CMO or a non-CMO ABS.
Cody, like everyone else involved, knew beyond any doubt what
particular security was at issue and understood it was a security
collateralized by housing installment loans and sales contracts.
Finally, Cody argues that FINRA and the SEC were wrong to
find that the three non-investment grade bonds he purchased for
James Bates were unsuitable. Cody says that James Bates began
withdrawing $2,500 per month from his account--higher than the
original plan of $2,000 per month--and so Cody needed to find
investments that paid a higher yield. Since investment grade bonds
did not pay a sufficiently high yield, Cody said that he "had to be
creative" and invest in non-investment grade bonds; and in fact
Cody sold them months later at a profit.
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As the SEC noted, Cody's explanation is doubtful in light
of the timing of the purchases;4 but in any event Cody had no
warrant for departing from the agreed investment strategy without
Bates' agreement. The fact that the investments ultimately turned
a profit does not make the purchases suitable when made. Eugene J.
Erdos, 47 S.E.C. 985, 988 n.10 (1983). The fault is taking the
risk without authority; whether the investment succeeds or fails
bears on civil damages but does not excuse professional
misbehavior.
As for the finding that Cody engaged in excessive
trading, which Cody also attacks, it appears well supported by the
numbers of trades already set forth and by the large commissions
generated by in-and-out trades by which investments are acquired
and resold within weeks or even days. Such a strategy is
inappropriate for unsophisticated investors who desire a low-risk
strategy to protect their retirement savings. See Rafael Pinchas,
54 S.E.C. 331, 338-39 (1999).
Cody says that the enforcers focused on only twelve
months for Lenore DeSimone and on sixteen months for James Bates
and should have obtained numbers for the entire life of each
account; but a year or more is not an insubstantial period and if
4
Cody purchased the Ahold bonds before James Bates' first
increased withdrawal, and he purchased the Calpine and Royal
Caribbean bonds within days of James Bates' first increased
withdrawal.
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a representative engages in unsuitable excessive trading for a
meaningful period of time, he should not be excused by the fact
that there was some other time that he may not have engaged in
excessive trading. See Jack. H. Stein, 56 S.E.C. 108, 118 n.30
(2003).
In a variant of this argument, Cody criticizes the
findings for concentrating on Lenore DeSimone's IRA instead of
considering all of the DeSimones' accounts together; but Lenore
DeSimone indicated that the accounts had different objectives, with
the IRA meant for safe bonds but with some other accounts geared
toward more aggressive or risky investments. So the focus was
entirely appropriate. See Frederick C. Heller, 51 S.E.C. 275, 279
(1993).
Next, Cody notes that FINRA did not find that he was
engaged in excessive trading with the wrongful intent of enriching
himself. But while subjective intent is relevant to churning
charges under the anti-fraud regulation of Rule 10b-5, Mihara v.
Dean Witter & Co., 619 F.2d 814, 821 (9th Cir. 1980), NASD's
suitability rule is violated when a representative engages in
excessive trading relative to a customer's financial needs, Erdos
v. SEC, 742 F.2d 507, 508 (9th Cir. 1984), regardless of
motivation, First Sec. Corp., 40 S.E.C. 589, 592 (1961).
Lastly, Cody stresses the fact that one of the exhibits
offered against him on the excessive trading charge, which
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presented turnover and commission to equity ratios for James Bates'
accounts, turned out to have errors and was excluded. Cody then
suggests that somehow the errors infected the entire analysis. The
panel admitted the other exhibits that underpin the charge; and the
Hearing Panel, Appeals Panel and SEC scrupulously avoided relying
on the flawed evidence.
Affirmed.
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